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Guest Post: The Foreign Exchange Market And CDS Spreads
Submitted by Douglas Borthwick of Faros Trading
The Foreign Exchange Market and CDS Spreads
We are continually amazed at movements in the foreign exchange market that come as a direct consequence of moves in peripheral 5-Year Credit Default Swaps (CDS). The chart below details the relative correlation of a GDP weighted basket of the relevant countries within the Euro. The relationship makes sense. When spreads blow out they do so because investor anxiety over Europe's credit position increases, anxiety over credit worthiness in Europe sees investors selling EUR/USD. However lately moves in the smaller peripheral components have been resulting in out-sized moves in the EUR. Something strange is a-foot.
The 'PIIGS', Portugal, Italy, Ireland, Greece and Spain, make up approximately 18.2% of a GDP basket-weighted Index. PIIG is only 6.34%, Ireland specifically makes up 1.75%, and Portugal 1.91%
However rumors today that Ireland and Portugal would require IMF assistance (something that would affect 3.66% of the overall basket,) resulted in the EUR/USD dropping from 1.3150 down to 1.3050. The rumors were later denied, and the CDS spreads came back in. However the damage was done.
What we are effectively seeing is price movement in the smallest and most illiquid markets (Ireland and Portugal 5 Yr CDS) dramatically moves the largest market in the world (EUR/USD spot). to put this disconnect into a more qualitative argument... While the CDS Spread in Ireland can be moved out by 10BPS by paying the offer in 15 Mio USD, thus resulting in the EUR/USD dropping 100 pips... In the FX market, someone would probably have to sell 3-5 Bio EUR/USD. Keep in mind it took the Japan's BOJ 22 Bio USD to move the USD/JPY price up 300 pips.
Given Ireland 5yr CDS moved out 15 Bps and its weighting in the basket is 1.75%, we would expect the news would contribute a widening of 0.2625 Bps. Given Portugal 5yr CDS moved out 25 Bps and its weighting in the basket is 1.91%, we would expect the news would contribute a widening of 0.4775 Bps.. Together the news should contribute about 0.74 Bps or .0074%. However the EUR/USD dropped from 1.3150 to 1.3050, or 0.8%...
As we stated above. It doesn't take much to move the CDS spreads, for example when a 20-50 Mio USD order in the CDS can realize a move equal to having sold 4 Bio EUR/USD. There is a disconnect.
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Rollover, Bitchez!
Ok, I'll bite.
Captain Obvious is suggesting to me that another possibility to there being an easy and so far unnoticed method of making a cool $5 billion with an investment of a mere $50m is that there is visible correlation between EUR and the CDS prices, but that there is no causation between them.
Read: if on Monday you spend a cool $50m (1:20 leveraged for good measure) to blow the irish CDS market up a percent, the market will (after a few minutes of bepuzzlement) shrug collectively and drive down your price and say 'thank you' for that somewhat unexpected (but welcome) transfer of $50m to their bank accounts.
Why? Because, unlike today, on Monday there might be no underlying 'credible rumor' about the Most Unfortunate Situation In Ireland that worried both CDS traders and EUR traders today, and causes them to watch each others charts.
(If, ad argumendo, you also control the rumor mill coming out of Ireland, you dont need $50m to influence CDS markets - you just need to know that a rumor is to come out, sooner than the other traders, and place your bets accordingly.)
But please by all means try out this method! We all need counterparties to our trades :-)
I was going for sarcasm and a little double entendre but thanks for "biting"... uh...well..nevermind
Hey and here I was under the false impression that you were going for the first post with as few words as possible, front-running all other first-posters, with amazingly low latency! :-)
what's 'Mio' supposed to mean?
Not sure why but Bio is Billion and Mio must be Million.
that is corect. and to you americans, these are the abbreviations we use in continental europe!!! wanna know where europe is? check your f... atlas or google it. then, and just then, although it is not relevant here, discuss european issues.
I found Europe on google. Just got lucky me thinks.
Protest in Belgium, Greece etc. i think europe is full of lying pricks who are too smart by far. Europeans? Yourapeon.
Modus, i just didnt care for your attitude. I like americans, most are good folks by nature. But fail to understand the lack of rebellion against the bankers who stole their currency, country and future for stinken pieces of green paper and their belief in a future dream of their own home and white picket fence. They are still in shock and denial. Stuck.
it was suppose to have "meye-oooh" attached...as in "oh mio, MEYE-oooh." if enough people join in you've got one hell of a party.
We have to start taking a quantum view of pricing. Spooky action at a distance, impossibility of accurate real time measurement, a price taking all possible paths at the same time. Time to lose the math PHDs and get some theoretical physicists at Goldman.
quantam mechanics ain't no theory, just ask Lehman or Greece.
The Swiss trade in quants all the time. Just look at a chart of anything vs. the CHieF.
Greenspan's cat is always dead every time you look in the box, but when you close the lid, the box starts thumpin' and dancing around on the floor -- quite spooky indeed! :D
Let's do some quick math. Soc Gen recommended buying the 3 year Greek Bonds for a yield of over 11%. If in three years the Euro trades down to par, then selling the Euro at 130 almost results in a break-even. Many players may be using the currency markets to hedge their exposure to Sovereign debt, for in the instance of the Euro it is a much deeper market than the CDS market.
interesting
FED buying PIIG debt too?
no way, Jose. They've got a Bear out west that's got their attention.
How are CDS' even legal?
I wish I had taken a big CDS out against MC Hammer 20 years ago
it's called "insurance" and as was discovered "just because there was no transaction doesn't mean wild and crazy things can't occur." again "the word is now trillions" which of course "only means it gives billionaires ideas."
Read 'The Big Short' by M. Lewis for history on CDS.
i smell an arb play with leverage that the world HF community can jump on....
Aye, capt'n, that be true and who says the HF (hedge funds, not HFTs) aren't already there and using POMO supplied liquidity leverage to ravage the fields?
Is right!
I think there is more leverage and shuffling going on in the FX market then ever.
Bubbles, bubbles everywhere, yet no one's dared to pop one.
Methinks hedge fund yield chasing is about to become a full contact sport.
Doing the math myself:
0.8% divided by 0.0074% is just about the margin level in 4X. I'm not seeing where this observation means much.
/:
Without this drop today, EUR/USD would have closed the week up nearly 3.5%, a bit of a stretch by any means. I think the Ireland story was just reversed engineered around the drop, same old carry on, good excuse for profit takers. A bit like that WJS article last week when the pair went into meltdown, then everyone realised that they already knew everything that was printed in the WSJ article, and decided they didnt care to begin with anyway.
Just comming back to this..this guy is off his fucking rocker, who let him loose on the people?
Fear of contagion. It only needs the first domino.
I sent this to Durden last night but apparently he ignores me.
Germany asks US to give up its IMF veto
Lagarde says French G20 to discuss wider use of SDR
http://jessescrossroadscafe.blogspot.com/2010/09/sdr-as-global-reserve-c...
THIS is the endgame.
This is from the recently released survey by Fitch Market Reseach, "Global Credit Derivatives Survey 2009"
"In contrast to the previous year, gross market values actually declined by 64% at year- end 2009 to $1.8 trillion (year-end 2008: $5.1 trillion), according to BIS statistics. This was attributable to spread tightening for virtually all cash and derivative credit products and structures following the various policy measures taken to normalize financial markets. Consequently, in a reversal of fortunes, net protection sellers benefited from this repricing while net buyers lost out, particularly those with exposures to lower rated corporate names. The semblance of a return to normality in market conditions also resulted in improving liquidity across various asset classes. This is partially reflected in lower bid-offer spread levels. Given the inconsistencies in gross market values reported in the survey, Fitch has chosen to use the BIS estimates and would like to highlight them due to the possibility of institutions misstating losses or gains when valuations are driven by model assumptions or hard-to-obtain market prices in an illiquid market for certain products. The uncertainty surrounding valuation issues also highlights the need for improving transparency and disclosure of CDx exposures."
Survey: Market Surprised By Negative Derivative PerceptionFED playbook: Euro down, dollar up= stocks down for a bit. Then, the dollar will fall again to conveniently bring the Santa Claus rally.
EUR/USD will hit 1.4 this year. (Imminent technical breakout supported by fundamentals. Stable and upgraded growth forecasts. Excellent Bund auctions. Highly credible ECB statements of not excessive asset purchase as the FED does). FED buys GS,BoA,ML,MS assets while ECB lends and purchases in an emergency to support 5 countries. There is a diff!!
AUD/USD will hit .9650 this year. Clear breakout at .9170 even while ZERO HEDGE was shouting about the over valuation of Aussie dollar.
I cant stop laughing every time I read a bearish post here about the imminent breakdown in eur/usd and aud/usd from the zillioneth day and yet AUD is quite clearly headed much higher.
And then comes your overwhelming support for Gold. Make no mistake. Gold is defintely headed higher but it is purely investment game and fiat currency will not fail. There will be a shift out of dollar to a euro immediate future (3,4,5 years) but fiat currency will never end. The sheer convenience, prosperity man kind has achieved is due to fiat system. But we will see a shift out of dollar into euro given the overwhelming weight of Chinese forex buying into euro bunds. During the phase out process. you will see Gold
You guys need to be a lil more balanced when you analyse. Throwing rhetorice at fiat system will not end it. Mark my words here: Gold will come down as fast as it goes. No one can store it for long term. We are not living in Old testmant times. But for the time Gold is headed 1300/30 and maybe 1500 pop after QE2. But I dont see Gold hitting $2000 ever!!! As fiat system will change over maybe in the next year and that will end the bull run in Gold.
The case for EURO is simple:
1. Growth is stable.
2. Only 5 countries with debt issues but the market knows its full extent and hence quantifiable.
3. The only central bank that does not intervene. (Swiss,BoJ,FED all intervene)
4. Most important though is super relationship developing between China and Core EU. Soon Fergusson will write a new book called EUROCHI: The Dimension!
So maybe zero hedge can be a bit more balanced about its analysis and be in the realm of reality rather than the impossible like the end of fiat system.
I found lots of interesting information here. I love zerohedge.
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